What Are Dow Futures and How Do They Work

A Basic Introduction to Dow Futures Contracts

As you gain more experience investing with different types of securities, you can choose to trade indexes such as the Dow Jones Industrial Average (DJIA) or the S&P 500. If you want to take advantage of leverage, you can trade futures contracts on the index instead of buying the underlying securities.

If you have little exposure to the futures market it might seem confusing, especially if you hear about Dow Futures and the influence they would have on the direction of the stock market. If you're perplexed by Dow Futures, familiarize yourself with the basics.

What Are Dow Futures?

A futures contract is a legally binding agreement between two parties (which can be individuals or institutions) in which they agree to exchange money or assets based on a relationship to a predetermined price of an underlying index.

It's not as complicated as it sounds, and it just means that two people get together and strike a deal in which they say, "If the Dow Jones Industrial Average index is at or above (a certain price) by a certain date (called the "final settlement date") then one party will pay another the difference between the actual closing price of the index and the predetermined price upon which we agreed when we entered into the contract."

Unlike an option, which gives the holder the right but not the obligation, to exercise the terms of the deal, in a futures contract, both parties have an obligation to perform their part of the deal.

Where Do Dow Futures Trade?

Dow Futures contracts trade on an exchange, meaning that the exchange serves as the counter-party of every position. Otherwise, you would always have to worry about the person who held the other side of your position not sticking to the contract.

If your counterparty were to go bankrupt, die, or be unable to fulfill their side of the deal, you would be out in the cold, and a perfectly good position could go belly-up because they couldn't live up to their side of the bargain. By having all of the futures contracts cleared through the options exchange, this risk is eliminated because the exchange serves to guarantee every position.

When Can You Trade?

Dow Futures start trading each day on the Chicago Board of Trade (CBOT) at 7:20 a.m. Central Time (8:20 a.m. Eastern Time), which is an hour and ten minutes before the stock market opens, allowing trading to take place so reporters and professionals can get an idea of the market sentiment.

That is, if a company reports huge earnings and the Dow Futures skyrocket, the odds are good that the stock market itself will raise as well. The opposite is also true. If some event takes place before the stock market opening that causes Dow Futures to drop, then a decent chance exists that stocks will also fall once the opening bell rings.

Buying Futures With Leverage

Dow Futures have built-in leverage, meaning that traders can use significantly less money to trade futures while receiving exponential returns or losses. This can allow traders to make substantially more money on price fluctuations in the market than they could by simply buying the stock outright.

The Dow Jones futures use a multiplier of 10, which means that Dow Futures use a 10-1 leverage or 1,000 percent. If Dow Futures are currently trading at 6,000, for example, a single futures contract would then have a market value of $60,000. For every $1 (or "point" as it is known on Wall Street) the DJIA fluctuates, a single Dow Futures contract has an increase or decrease of $10.

As a result, a trader who believed the market was going to rally could simply acquire Dow Futures with a smaller amount of money and make a huge amount of profit as a result of the leverage factor. If the market were to return to a level of 14,000, for instance, from the current 8,000, each Dow Futures contract would gain $60,000 in value (6,000 point rise x 10 leverage factor = $60,000). It's worth noting that the opposite can also easily happen. If the market were to fall, the Dow Futures trader could lose huge sums of money.